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With assistance from Antonella Schiavello Senior Associate MinterEllison Nathan Krapivensky and Hilary Taylor Lawyers MinterEllison
opinions in this paper are those of the author andd not review the contents of this paper and does npinions in the paper should not be used or treatedeir own enquiries in making any decisions concer
1st NATIONALCONVENTION
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Written by: Joanne Dunne Partner MinterEllison
National Division 2-4 March 2016
Grand Hyatt Melbourne
d not those of The Tax not have any view as to its d as professional advice rning their own interests.
1.1 Case Study ............................................................................................................................... 3 1.2 High level questions from the case study ................................................................................. 5
2 Australian small business transitioning to have a digital presence ........................................... 6
2.1 Overview of issues other than tax that need consideration ...................................................... 6 2.2 Case study: Australian tax issues for ITNB .............................................................................. 8
2.2.1 Income arising to ITNB ................................................................................................ 8 2.2.2 Tax deductions and tax offsets available to ITNB ........................................................ 8 2.2.3 GST ............................................................................................................................ 14
2.3 Record keeping for tax purposes ............................................................................................ 16
3 Going global - expanding the digital business outside of Australia ......................................... 18
3.1 Overview of fundamental concepts to consider ...................................................................... 18 3.2 Issues digital businesses need to consider when expanding offshore ................................... 19
3.2.1 ITNB Singapore Ltd as a controlled foreign company – issues for ITNB .................. 19 3.2.2 ITNB Singapore Ltd – Australian tax residence ......................................................... 21 3.2.3 ITNB Singapore Ltd – source and the nature of income ........................................... 21 3.2.4 Permanent establishment .......................................................................................... 26 3.2.5 Transfer pricing .......................................................................................................... 29 3.2.6 GST ............................................................................................................................ 30 3.2.7 Digital currency .......................................................................................................... 31
1 Overview The digital economy is becoming harder to distinguish from the rest of our economy as Australian businesses embrace technology across a wide variety of industries.
There have been a number of studies which have sought to analyse how digital technology and digital business is transforming the Australian economy. To mention just one study, in 2015 Deloitte Access Economics’ The Connected Continent II report (prepared for Google Australia) estimated that Australia’s digital economy contributed $79 billion to the Australian economy, or 5.1 percent of GDP.1 This was an increase in value of approximately $29 billion in 5 years.2 Deloitte Access Economics estimated that by 2020 the digital economy will contribute $139 billion to the Australian economy or 7.3 percent of GDP. The Deloitte Access Economics report also highlighted the transformative nature of the digital economy in sectors such as retail, banking, professional services and Government, and the productivity benefits from the use of digital technology.
As part of its Base Erosion and Profit Shifting (BEPS) Project, the OECD recognised that taxation systems have not necessarily adapted to take account of technological advancements and the growth of the digital economy. Action 1 of the BEPS Project was established to consider those issues. In its final report Addressing the Tax Challenges of the Digital Economy3 the OECD noted that the digital economy globally has been transformative, and that key features of the digital economy (such as so-called stateless income) may exacerbate base erosion and profit shifting risk. A number of proposals were made by the OECD and issues from that paper and the BEPS Project generally are highlighted in this paper.
This paper has the monumental task of considering "Tax Issues for Digital Business". There are obviously a wide array of issues. As there are such a wide array of issues, this paper approaches the topic by using a case study to demonstrate the practical issues that arise. The case study focuses on digital economy specific issues as opposed to the more generalised tax issues that would apply to all businesses, digital or otherwise.
The case study considers the tax issues that arise for a small Australian retail business transitioning to have a digital presence firstly in Australia only, and the additional tax issues which arise when that business grows and expands overseas establishing an offshore subsidiary. Issues such as the use of digital currency are also touched upon. The PowerPoint presentation will also approach this topic on the basis of this case study.
1.1 Case Study
Paul Michaelson and Jane Johnson are fashion entrepreneurs from Fitzroy in Melbourne.
1 See Deloitte Access Economics report at http://www2.deloitte.com/au/en/pages/economics/articles/connected-continent.html 2 See Deloitte Access Economics report The Connected Continent (2011) which considered 2010 figures at http://www2.deloitte.com/au/en/pages/economics/articles/connected-continent.html. 3 OECD (2015), Addressing the Tax Challenges of the Digital Economy, Action 1 - 2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris. DOI: http://dx.doi.org/10.1787/9789264241046-en
Paul is a well-known personal shopper, and Jane is a stylist and personal grooming consultant. Paul and Jane employ four personal shoppers and their business enjoys a loyal clientele including hipsters from Fitzroy, and elite clientele from Brighton, Toorak and South Yarra, as well as Tasmanian based clients.
Paul and Jane operate their business through an Australian company of which they are the directors and their family trusts are 50/50 shareholders. The company is called It's The New Black Ltd (ITNB) and it has an office in Melbourne (in Fitzroy). In the last financial year ITNB's aggregate turnover was $1.7 million. ITNB's assets consist of inventory supply and advisory contracts with large department stores, client contracts and occasional events contracts (such as with Victoria Racing). These assets need regular renewal and are not long term assets.
ITNB intends to expand its business beyond Victoria and its current Tasmanian clients.
Paul and Jane have also decided that their business will grow and develop further in their current market in Australia if they have an online presence. Paul and Jane have decided they first want to test interest in NSW, WA, Queensland, the ACT, the Northern Territory and South Australia by way of an online presence only.
They also think this will also enable them to consider whether to open offices in Australia outside of Victoria by way of monitoring who goes onto and uses the website and where they are located.
Paul and Jane tell you that:
• A website has been designed for ITNB by an Australian based design company in return for a fee. • ITNB has entered into a short term hosting agreement with Macquarie Telecom in Australia, and they
advise that they understand that the hosting will be via servers located in Australia. • ITNB is currently negotiating an agreement with Paris and London Fashion Weeks to enable a live
signal of particular avant garde fashion shows to be broadcast exclusively on the ITNB website. • ITNB has acquired off the shelf software, and over the past few months Paul has made innovative
adjustments to that software to enable clients to input their measurements, upload a photo, advise the event they are attending, and be instantly recommended a range of outfits. The recommendations would be shown on the client's body so they can see before they buy. An advisory fee and website access fee is charged by ITNB for this service.
• They are working to ensure that the website has functionality so that clients can request grooming and design advice from the ITNB team. An advisory fee is charged by ITNB for this service.
• They are also working to ensure that the website has functionality to enable shoppers to search for and request particular designer fashion. If a customer makes a booking ITNB is paid a fee by the customer for the use of the website for this purpose, and a commission is also obtained from the particular designer if a purchase is made.
• ITNB has entered into inventory contracts with a number of stores and designers in Australia to be able to access products.
• The website is expected to 'go live' in the next two months.
Paul and Jane have hired a technical person Brian Block to assist them to ensure that at all times the website is providing fast, effective service to its customers. They also want to be innovative and respond to trends to meet customer need.
Following the website going live, some months later the business grows at an exponential rate, with turnover exceeding $20 million. Paul and Jane and their technical person Brian Block work on, test, and design an App which provides the ability for clients to reserve particular items of inventory as soon as it
comes in using their smart phones. Brian also tells Paul and Jane that the website should be hosted in the 'cloud', and they want to understand the potential tax implications of that.
After a period of time of operating the website, ITNB also becomes aware that large numbers of potential new clientele are based outside of Australia in various jurisdictions in Asia. ITNB is considering establishing a subsidiary company in Singapore, to be owned 100% by ITNB, and expanding its inventory contracts beyond Australian based designers to Asian based designers.
Further, due to the increase in the use of digital currency, Paul and Jane have decided that ITNB may commence accepting bitcoin as a form of payment from their clients. They ask for advice about the tax implications.
1.2 High level questions from the case study
Australian small business transitioning to have a digital presence - Initially Paul and Jane are focusing only on Australia – with the varying issues outlined above requiring consideration. What are the tax issues ITNB needs to consider?
Going global - Expanding the digital business outside of Australia - When expanding its business offshore what tax issues does ITNB need to think about?
Digital currency - What are the relevant tax issues to consider when thinking about accepting bitcoins? Should ITNB accept bitcoins?
2 Australian small business transitioning to have a digital presence
2.1 Overview of issues other than tax that need consideration
When an Australian business considers establishing a digital presence, it will need to consider a range of issues other than tax. Those issues include the following:
(a) Structuring and registrations – These issues include considering what is the appropriate business structure for the digital business (eg company, incorporated association, trust, partnership). Practical matters such as obtaining an ABN and GST registration also need to be dealt with. On the facts of our case study, those issues have already been considered and dealt with, and the existing company ITNB has an ABN, is GST registered, and will operate the website.
(b) Website hosting – There are a number of hosting options that internet service providers can offer. Hosting can also occur in the 'cloud'. ITNB has instead, at the outset, determined to have its website hosted on a short term basis by an Australian internet service provider on Australian based servers. For the purposes of the case study, we have assumed an infrastructure as a service package. The nature of the 'cloud' and the various hosting options are touched on later in this paper when the potential for ITNB to expand offshore is considered.
(c) Intellectual property law issues – The business will need to ensure that its name and its domain name do not infringe upon any other name of any other business, and intellectual property law advice should be sought to ensure that trademarks, and copyright in the trademark and website design are protected. In terms of the domain name, reserving names that are misspellings of or close to the business' domain name is sensible to ensure that customer access is enhanced. Consideration of whether to have a domestic or international domain (for example the suffix .com.au or just .com or .net), as well as the length of time a domain name is registered for will be important factors to consider. Obtaining a domain name from an Accredited Registrar is sensible, as Accredited Registrars have access to domain names on AusRegistry and are subject to a code of practice. There is plenty of useful government guidance about a number of these issues (amongst other practical matters), including how to search the trademark register, who are Accredited Registrars, how to check whether domain names are currently registered.4
(d) Consumer law issues – If the business is engaged in selling products and services online (like ITNB in our case study will be), care needs to be taken with the description of those products and services to ensure that they are not misleading or deceptive in any way. Compliance with Consumer Law requirements both at State and Federal levels may be required.5 If the business intends to operate offshore, compliance with international consumer law regimes will also need to be considered. Customer care and customer service and how to manage inquiries also needs consideration. A lot of digital businesses utilise call centre services for this purpose, and how to manage and cost this needs commercial consideration.
4 A suggested resource is https://www.communications.gov.au/what-we-do/internet/digital-business/creating-your-website. 5 Useful resources include https://www.accc.gov.au/consumers.
(e) Terms and Conditions – Terms and conditions of contract or terms of trade should be drafted and provided on the website to set out the terms of the contract between the business and the customer. This would include issues such as what fees will be charged for services, what fees are for, payment terms, privacy issues (see below for further comment regarding those issues), warranties, protections for the business' intellectual property, if goods are to be supplied how they are to be transited and at whose cost, and risks during transit. The terms and conditions would also set out issues that would impact on tax – such as where contracts are concluded and how they are concluded. The issues relating to taxation and source are considered later in this paper.
(f) Security and Privacy law issues – Businesses operating in the digital economy need to ensure that customer information including details such as credit card information is stored securely. Technical advice will need to be sought. In terms of payments from customers, creating a merchant account so that credit cards can be accepted and considering arrangements with credit card companies to utilise secure facilities6 will be important. In addition, making arrangements with online payment services such as PayPal so that their secure facilities can be used provides security and payment flexibility for customers. Steps need to be taken to protect data from unauthorised access and to prevent fraud. Ensuring that the website appropriately manages the privacy law issues is also critical. Those issues arise at both State and Federal level. In relation to ITNB and the case study, personal data will be collected about customers, including potentially photographs, body measurements, as well as address and payment data. It will be important to ensure that there are adequate protections and security of such personal data, that ITNB has a privacy policy and that the terms and conditions on the website adequately deal with the privacy law.7 Cyber risk or cyber liability insurance products can also be a good way to protect the business in situations of security breach, privacy breach or inoperability, and insurance companies offer a range of products which should also be considered.8
(g) SPAM – If the business chooses to utilise customer lists for marketing (which is commonplace), it will need to ensure that there is compliance with the SPAM Act 2003 (Cth). Amongst other matters, this legislation requires there to be consent or implied consent before marketing material is sent, and for there to be an ability for customers to unsubscribe from such material.
(h) Advertising and social media – There is a lot of both governmental and non-governmental advisory material on the internet for small businesses seeking to enter the digital economy. Much of that material considers what social media tools to utilise to advertise the business.9 A critical part of advertising a digital business includes entering into arrangements with Google for services such as Google AdWords which enables the business to access 'click marketing' and considering what social media sites the business will participate in and regularly update. An advertising and social media strategy is another critical issue to consider.
If ITNB has not considered those issues, its tax adviser should advise ITNB of those issues and to seek specialist advice. A large number of law firms and accounting firms have specialist advisers that can assist. For the purposes of the case study, it is assumed that those issues have been considered and no further comment is provided in this paper.
6 Such as Mastercard Secure Code see https://www.mastercard.us/en-us/consumers/features-benefits/securecode.html. 7 Further detail (including links to relevant State/Territory regimes) can be found on the website of the Office of the Australian Information Commissioner https://www.oaic.gov.au. 8 See for example an article by Marsh http://australia.marsh.com/RiskIssues/CyberRisk.aspx. 9 For example see, http://woofmedia.com.au/5-social-media-marketing-tools-for-small-business/ and http://www.business.vic.gov.au/marketing-sales-and-online/online-business-and-technology/social-media-for-business/managing-social-media.
Income received by ITNB from customers by way of advisory fees, website access fees, booking fees and commission from designers will be assessable income to ITNB in Australia, as it is derived by an Australian resident from carrying on a business in Australia.10
2.2.2 Tax deductions and tax offsets available to ITNB
The case study states that ITNB has advised that it has already incurred expenses in having the website designed by an Australian based business. It has also entered into a short term hosting arrangement with Macquarie Telecom. Legal and advisory costs will also necessarily have been incurred in ensuring that the legal issues and other issues noted in paragraph 2.1 above are appropriately dealt with. ITNB will derive assessable income from the website, as is noted above. This means that the first issue for ITNB is considering the deductibility of the expenses to develop and establish the website.
Section 8-1 of the Income Tax Assessment Act 1997 (Cth) (ITAA 1997) provides for a deduction to the extent the loss or outgoing is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income. What particularly needs consideration is whether section 8-1(2) might prevent a deduction as the expenditure may be an outgoing of capital, and if that is the position, whether there might be another avenue provided under the ITAA 1997 or the Income Tax Assessment Act 1936 (Cth) (ITAA 1936) for a tax offset or deduction.
Website expenditure and development costs
The website design expenditure may be deductible under the general deduction provisions in section 8-1 of the ITAA 1997. This might occur if the website had little functionality and performed an advertising task only. In that event expenditure creating that website may well be deductible as an ordinary business expense under section 8-1. For ITNB this will not be the position, as the website as described in the case study has greater functionality than mere advertising.
In the case of ITNB, more detail would be needed as to whether the costs being considered as "website expenditure and development costs" are one-off or more regular in nature. For example, some of the website design costs may include fees for updating or testing the operation of the website going forward. At least some of the costs may be more recurrent in nature, and may be in the nature of revenue expenses. For example, ITNB should be entitled to claim a deduction for the ongoing expenses of running and maintaining its website, such as domain name registration costs and server-hosting package costs and ongoing fees paid to Macquarie Telecom. These costs should able to be claimed in the income year that the expense was incurred, pursuant to section 8-1 of the ITAA 1997.
In terms of the other website development and design costs, it is likely that expenditure incurred by ITNB is capital in nature. This is because the website establishes a new business earning structure for ITNB. Unless there are specific provisions providing a deduction the expenditure is not likely to be deductible under section 8-1.
10 For completeness, we note that in terms of the tax rate applicable to that income, the company tax rate for small businesses such as ITNB (ie with aggregated turnover of less than $2 million) has been reduced from 1 July 2015 to 28.5%.
In 2009, the ATO withdrew TR 2001/6, which addressed the deductibility of website development and establishment costs. The ATO website states that the ATO is currently in the process of developing a new ruling. As part of this ruling development process, the ATO states that it is consulting with tax and industry representatives to discuss the issues and scope of the ruling. It has been a significant period waiting for the new ruling. The issue TR 2001/6 considered was whether the costs were to establish a profit yielding structure, and hence capital, and even if they were, whether the ITAA 1997 or ITAA 1936 might provide a deduction. The ruling provided some useful examples.
In the interim, while a new ruling to replace TR 2001/6 is being considered, the ATO has provided some limited guidance on its website.11
ITNB will be a 'small business' as the case study states it has an aggregated turnover of less than $2 million. That means that the Government's small business tax changes as announced in the 2015-16 Federal Budget may provide potential enhanced upfront asset write off. As is noted in the ATO guidance, assuming the expenditure is incurred between 12 May 2015 and 30 June 2017, section 328-180 of the ITAA 1997 provides that certain capital expenditure can be claimed as a deduction in the income year that the expenditure was incurred (assuming the cost is less than $20,000). However, those potential deductions are limited to situations where there is a depreciating asset as defined in section 40-30 of the ITAA 1997.
If the cost of those assets is $20,000 or more, the simplified depreciation rules in Subdivision 328-D of the ITAA 1997 may be applicable if ITNB elects to use those rules, or Division 40 will need to be considered. Again, this is relevant only to the extent there is a depreciating asset.
The definition of depreciating asset refers to an asset with a limited effective life that can be reasonably expected to decline in value. It does not seem likely that the website itself could fall within that concept. In the case of ITNB's website, depreciating assets would likely only comprise in-house software (which may arise in ITNB's case because of Paul's software adjustments or the App development described in the case study) or intellectual property as defined in section 995-1 of the ITAA 1997. In-house software is considered separately below.
The intellectual property definition in section 995-1 requires there to be rights in a patent, copyright or registered design. For ITNB, there may be rights in a design of the website (for example the ITNB brand design). Those rights could comprise a design that could be registered, or could comprise copyright.
When considering whether there is intellectual property as defined, the website program itself may also need to be considered. In TR 93/12, the ATO considered that a computer program is in essence knowledge or information and may be considered an item of intellectual property, and may be subject to copyright.12 Businesses such as ITNB may have copyright protection over internally created computer programs, such as the innovations Paul has made to the software or the App. The whole of ITNB's website will not be protected by copyright, however, component parts of the website such as text, images, logos, source code and files may be protected.13 Division 355 (research and development) is considered separately below, and it too will be a factor that ITNB would need to consider in relation to Paul's software development and the App development.
11 https://www.ato.gov.au/tax-professionals/newsroom/activity-statements/claiming-website-development-costs/. 12 Note that the Copyright Act 1968 (Cth) may apply to provide protection and registration is not required for that protection to be applicable. For protection to arise the work must be in a material form. This means that a form of the work or an adaptation of the work is stored and capable of being reproduced. The work must be made by a person who is an Australian citizen or resident of Australia when the work was made. The work must be an original work that is the result of the author's skill and effort. 13 See Australian Copyright Council, Information Sheet December 2014 Websites and Copyright.
For other costs, outside those that are related to obtaining a depreciating asset or Division 355, the following additional issues need to be considered:
CGT assets may arise (for example for certain intellectual property that does not otherwise meet the rather narrow intellectual property definition in section 995-1) and the costs may form the cost base for that asset.14
To the extent of black hole expenditure15 on website design and development, section 40-880 could apply to provide ITNB a deduction over five years.16
For example, as is noted above, legal costs may be incurred in drafting terms and conditions for the website, or providing advice on the various issues noted at paragraph 2.1 above. Those costs are likely capital in nature, although they can may form part of the cost base for a CGT asset, or part of the cost of a depreciating asset (eg legal costs in registering a copyright). Otherwise, for those costs to be deductible section 40-880 of the ITAA 1997 would need to be applicable.
Off the shelf software and computer hardware
The purchase of the off-the-shelf software by ITNB should be deductible under section 8-1 of the ITAA 1997. The ATO's guidance on its website confirms that cost of commercial off-the-shelf software is generally deductible in the year of purchase.17
ITNB may also have acquired computer hardware. This may have occurred given the hiring of Brian Block to carry out IT functions, and Paul's efforts in making innovative adjustments to software. Any such computer hardware this should be depreciable under Division 40 or, if elected by ITNB, Subdivision 328-D of the ITAA 1997. Alternatively, as is stated above, as ITNB will be a 'small business', assuming the expenditure is incurred between 12 May 2015 and 30 June 2017 and is less than $20,000, section 328-180 of the ITAA 1997 provides that certain capital expenditure can be claimed as a deduction in the income year that the expenditure was incurred.
Innovations to software and the App development
Special rules apply to deductions for the cost of developing in-house software for a taxpayer's own use. In-house software as defined in the ITAA 1997 is computer software that is acquired or developed and is mainly for use in performing the functions for which it was developed, and, importantly, for which no other provision of the ITAA 1997 provides a deduction.18
For that reason, before considering whether Subdivision 328-D or Division 40 applies, when ITNB is determining its tax position for the costs of Paul making the adjustments to the software and any other development costs, ITNB will need to first consider the research and development provisions in Division 355 and any other provisions in the Act.
14 Given ITNB is a small business, the various small business concessions may be available to it in future in respect of any such CGT assets. 15 That is, none of the above provisions apply – for example, there is no other form of deduction available, and a CGT asset does not arise. 16 The application of section 40-880 to provide deductions for website related expenditure is supported by the attached Private Ruling (reference 1011958172383) – see https://www.ato.gov.au/rba/content/?ffi=/misc/rba/content/1011958172383.htm. 17 See https://www.ato.gov.au/business/depreciation-and-capital-expenses-and-allowances/other-capital-asset-and-expense-deductions/ - this assumes the software has an effective life of one year or less, or for periodic payments to use software. 18 In the context of the research and development provisions, section 355-715 provides that other than where the adjustment provisions in section 40-292 and section 40-293 are applicable, if an R&D tax offset arises, depreciation cannot be claimed under Division 40 or any other Division of the Act as well. That provision also confirms that considering the research and development provisions first will be important.
The research and development (R&D) provisions are outlined in Division 355 of the ITAA 1997. Assuming it is conducting eligible R&D activities, because its aggregated turnover is less than $20 million, ITNB may be entitled to receive a 45% refundable tax offset. In order to claim an R&D tax offset, ITNB must register the R&D activities at Innovation Australia,19 must have notional deductions for the purposes of the R&D provisions of at least $20,000 for the income year, and must carry out the activities for itself (generally) in Australia.
Assuming those issues to be satisfied (for instance salary and wages for Brian Block can form part of the expenditure taken into account when considering notional deductions),20 there are a number of factors that ITNB will need to consider when determining whether Paul's innovative software amendments, or the later design of the App by Brian Block, Paul and Jane are eligible R&D activities.
Under Division 355 of the ITAA 1997, companies are entitled to an R&D tax offset based on their notional deductions in respect of R&D activities. Notional deductions refers to the expenses on incurred in conducting eligible R&D activities or the decline in value of tangible depreciating assets used in R&D activities.
ITNB may be eligible for a tax offset for R&D activities if the following requirements contained in Division 355 are satisfied:
(a) ITNB is an 'R&D entity', which includes companies incorporated under Australian law;21 - this is satisfied - and
(b) the activities conducted by ITNB in relation to its software development or App development are either core R&D activities or supporting R&D activities.22
Core R&D activities are defined in section 355-25 as:
(a) experimental activities where the outcome cannot be known or determined in advance on the basis of current knowledge, information or experience but can only be determined by applying a systematic progression of work based on principles of science and which proceeds from hypothesis to experiment, observation and evaluation, and leads to logical conclusions; and
(b) that are conducted for the purpose of generating new knowledge (including new knowledge in the form of new of improved materials, products, devices, processes or services).
Specifically excluded from being a core R&D activity is developing, modifying or customising computer software for the dominant purpose of use for internal administration. Because Paul's software innovations and the App development are described as being for use by customers, they should not fall within that concept.
Section 355-225(2) provides that expenditure on acquiring technology or the right to use technology may not be available under the R&D provisions – this could include for instance the computer hardware and the off the shelf software that Paul applied innovations to. This in and of itself may not be troublesome given the potential availability of deductions under other provisions.
19 Note the deadline for registration is ten months after the end of an income year: see http://www.business.gov.au/grants-and-assistance/innovation-rd/RD-TaxIncentive/Pages/default.aspx#. 20 See pages 14-15 of https://www.ato.gov.au/business/research-and-development-tax-incentive/in-detail/guides--ato/research-and-development-tax-incentive---amounts-you-can-claim/. 21 Subsection 355-35(1). 22 Section 355-20.
Supporting R&D activities are defined in section 355-30 as activities directly related to core R&D activities. It is therefore important to show that core R&D activities arise.
ITNB will need to evidence all the activities to provide support that they are eligible R&D activities, and provide evidence of its expenditure.
When determining if it is carrying out any core R&D activities, ITNB will need to show that the software innovations and App development are in fact new, and evidence the work done. Cases such as Re North Broken Hill Ltd and Industry Research and Development Board 93 ATC 2148 and RACV Sales and Marketing Pty Ltd v FC of T 2012 ATC 10,254 (which considered the former R&D provisions) show that evidence will be needed showing that the work done develops new knowledge, and that there was technical uncertainty about the outcome. In the North Broken Hill case for example, innovations to off the shelf software were not held to comprise R&D activities because they were not innovative, as it could not be shown that the outcome was uncertain.
Innovation Australia issued Guideline 17 in relation to software development relating to the former R&D provisions. While that Guideline is not about or applicable to the current R&D provisions, it refers to software development as needing to embody algorithms or methodologies that did not previously exist, and needing to show sufficient innovation and outcome risk. It gives guidance that should be taken into account by ITNB when considering how to evidence its activities to support an R&D claim. In the context of the ITNB case study, to show that the software could not be developed from current knowledge or information, ITNB could conduct a literature and technology review to conclude that no algorithm capable of performing image recognition and then 'fitting' the clothes on the client's photo existed previously. Similar evidence would need to be found about the App. Evidence would also need to be found that the outcome of the work done was uncertain.
Evidence of an progressive experimental process will also be needed to meet the core R&D activities definition. It is stated in the case study that the App was 'worked on, tested and designed' and evidence of that process will also be needed to show the systematic progression of work to meet the definition of core R&D activities in section 355-25. The case study does not refer to what documentation Paul kept, and what process he entered into to develop the innovations to the software.
ITNB will need to provide further evidence before an R&D claim can be substantiated.
For completeness, to obtain certainty, an advance finding could have been sought by ITNB from Innovation Australia23 as to whether the activities are eligible R&D activities. ITNB could apply to Innovation Australia for such an advance finding in respect of its R&D activities, and the finding, if obtained, would be binding on Innovation Australia and the ATO for the year in which the R&D is conducted and for up to two subsequent years (if the activities are being conducted over multiple years).
In-house software – Division 40 and Subdivision 328-D
The software developed by ITNB comprised in Paul's innovations and the App may satisfy the definition of in-house software assuming no other provision in the ITAA 1997 (such as the R&D provisions) is applicable to provide a deduction. If the costs of development are less than $20,000 ITNB may be able to obtain an immediate deduction under section 328-180 of the ITAA 1997.
Assuming that the costs of development are greater than $20,000, assuming it commenced to be held after 1 July 2015, if it satisfies the definition of in-house software, ITNB's in-house software has a
23 See http://www.business.gov.au/grants-and-assistance/innovation-rd/RD-TaxIncentive/Eligibility/Documents/RandDTaxIncentive-AdvanceFindingInformationSheet.pdf.
statutory effective life of five years and must be depreciated using the prime cost method.24 ITNB cannot self assess the effective life or use the diminishing value method.
Alternatively ITNB can choose to allocate in-house software to a software development pool, which is depreciated at specific rates. Once ITNB allocates any of its software expenditure to a pool, it must allocate all such future expenditure to a pool. There is no deduction for expenditure in a software development pool in the income year in which it the expenditure was incurred. ITNB is allowed deductions at the rate of 40% in each of the next two years and 20% in the year after that.25
Payments to Paris and London fashion weeks – royalties?
The case study states that ITNB is currently negotiating an agreement with Paris and London Fashion Weeks to enable a live signal of particular fashion shows to be broadcast exclusively on the ITNB website. An important issue for ITNB is whether any payments made to Paris and London fashion weeks would be deductible. That seems possible under section 8-1 of the ITAA 1997, but a critical factor is determining whether the payments would be royalties, as section 26-25 of the ITAA 1997 may prevent a deduction unless withholding tax obligations have been met. Both the Australia/France and Australia/UK double tax treaties would also need to be considered.
Seven Network Limited v Commissioner of Taxation [2014] FCA 1411 is relevant in this context. This case is relevant to the case study particularly when considering payments made by ITNB for broadcasting rights to Paris and London fashion weeks, and whether such payments are royalties which are subject to withholding tax. In that case the Federal Court considered whether payments (totalling approximately $97.7m) made by the taxpayer to the International Olympic Committee (IOC) for the broadcasting rights for the Olympic Games were a royalty within the meaning of the Australia/Switzerland Double Tax Treaty, and were subject to withholding tax. The payments were consideration for the Signal Utilisation Deed, including the use of the ITVR signal by the taxpayer to broadcast the Olympic games in 2004, 2006 and 2008 (other payments made by the taxpayer were agreed to either be or not be royalties, and were not in contention).
The issue revolved around Article 12(3) of the Australia/Switzerland Double Tax Treaty and whether the use of the ITVR signal was the right to use copyright, or any other like property or right which could make payments in relation to the ITVR royalties.
The Court accepted the evidence that the ITVR signal was data, and not itself images or things. The signal was also not embodied in any article or thing. The Court accepted that the item must be able to be reproduced in tangible or material form to be an embodiment and comprise copyright. For that reason, and relying on previous case law, the Court held the signal could not be a cinematograph film (for copyright law purposes) and copyright did not arise in accordance with the Copyright Act 1968 (Cth).
The Court then considered the meaning of the words any other like property in Article 12(3). The Commissioner maintained that the words included the use of any rights that are broadly of a similar nature. The Commissioner maintained that the concept included subject matter that is the result of creative effort and that was capable of being shared or exploited. The taxpayer maintained that the words were more narrow in scope and encompassed rights given statutory recognition as intellectual property rights in the domestic legislation of Australia or Switzerland.
24 Subsection 40-70(2)(a), subsection 40-72(2)(a), section 40-75 and subsection 40-95(7) of the ITAA 1997. 25 Section 40-450 and section 40-455 of the ITAA 1997.
The Court agreed with the taxpayer, and held that the words any other like property in Article 12(3) referred to intellectual property rights protected under domestic law. The Court held no such rights arose. The Court made a declaration holding the payments were not royalties, that withholding tax was not required to be deducted. This case is under appeal to the Full Federal Court and the outcome is expected in 2016.
In ITNB's case, when considering the live signal from Paris and London fashion weeks, again, insufficient evidence is provided to consider whether those payments are royalties or not. Further questions would need to be asked, and ITNB's tax adviser would need to see the agreements at issue. The outcome of the Seven Network appeal (when known) will also be of obvious relevance.
In addition, whether the website access fees paid by customers are royalties may need to be considered. This is not so much of an issue in relation to ITNB when it is operating the website domestically only as the fees will be taxable in any event, the website is hosted in Australia, and the customers are all Australian resident. Care would need to be taken to describe those access fees appropriately as being for a service. However, the nature of those fees and the question of whether they are royalties paid in return for a non-transferrable, non-exclusive right to use the intellectual property or software comprised in the website may become relevant in future if ITNB builds an international client base and derives fees from offshore. The issue might also be relevant as ITNB expands offshore, establishing ITNB Singapore Ltd, and the Singapore company derives such fees from Australian customers. This latter issue is further considered below.
2.2.3 GST
As we all are aware, under the A New Tax System (Goods and Services Tax) Act 1999 (Cth) (GST Act), GST is imposed at a rate of 10% on supplies that are taxable supplies or taxable importations. Entitlements to input tax credits arise on creditable acquisitions and creditable importations. Amounts of GST and amounts of input tax credits are set off against each other to produce a net amount for a tax period, this represents the amount that the entity must pay or the amount that may be refunded.26 For profit entities that meet the registration GST turnover threshold of $75,000 are required to register for GST.27
In the case study, ITNB is a pre-existing business with a substantial turnover already. It is assumed that it is registered for GST.
The issue for ITNB, is whether supplies made by way of its website would be a taxable supply. For the supply to be a taxable supply, the supply must be:
made for consideration; and in the course of furtherance of an enterprise that is carried on by ITNB; and connected with the Australia; and made by a registered person such as ITNB.28
ITNB clearly carries on an enterprise, and makes a number of supplies to customers via its website and also provides services to clothing designers. For example, the supply of advice to a customer is a supply as it is the provision of a service. Designers receive the service of promoting their clothing on the ITNB website. Payments are received by ITNB from its customers and/or designers for those supplies.
26 Sections 7-5 to 7-15 of the GST Act. 27Section 23-15. 28 Section 9-5 of the GST Act.
In terms of the connection with Australia, a supply of goods is connected with Australia if the goods are delivered, or made available, in Australia to the recipient of the supply. In respect of the clothes sold to customers, these clothes are delivered to customers in Australia, and will clearly be connected with Australia. ITNB is already (we assume) GST registered. Fees for the supply of clothing should be subject to GST.
A supply of anything other than goods is connected with Australia if the thing (which includes a service, information or right) is done in Australia or ITNB makes the supply of the service through an enterprise that the supplier carries on in Australia. GSTR 2000/31 states that where something is done will depend on the nature of the supply – generally for services this is where the services are performed. So here, for ITNB, its advisory services will be performed by staff in Australia, to customers in Australia. The facts also suggest that the services for designers are also performed in Australia. GST would arise in respect of fees for those services, GST would arise.
An interesting issue arises if the terms and conditions on ITNB's website described the service the customer was receiving as a limited, non-transferable license to use the software which is part of the website. This is fairly common.29
In this event, for GST purposes the thing refers to the computer software and done refers to where the services are performed.30
In the context of the supply of services in relation to ITNB's online software, the location of the ITNB (as service provider) and servers are relevant factors. The Commissioner has in various private binding rulings issued to taxpayers determined that the supply of online services by a foreign company to Australian customers is a thing not done in Australia where the foreign company's servers are not in Australia.31
Under the case study's factual scenario, ITNB carries on its enterprise in Australia, and all supplies are connected to Australia in any event – whether the service is the supply of a licence to use the software, or goods or otherwise. In addition, the software was has been acquired by and developed by ITNB in Australia and the servers and related IT infrastructure which support the computer software are also located in Australia, and Macquarie Telecom is providing hosting services. Accordingly, it is likely that the supply of the computer software is a thing done in Australia, and therefore is connected with Australia.
This means that as ITNB makes taxable supplies in its provision of clothes, computer software to customers and services to designers, GST will be imposed at a rate of 10% on the consideration for these supplies.
In relation to the costs ITNB has incurred to establish the website, the acquisition of the initial software, the hosting agreement, and the inventory contracts are considered for the purpose of determining ITNB's creditable acquisitions for GST purposes. It is concluded that ITNB should have entitlements to input tax credits arise on these creditable acquisitions which may be offset against its amounts of GST to produce a net amount for a tax period.
For a creditable acquisition to arise, the acquisition must be:
• for a creditable purpose • a taxable supply; • for consideration; and
29 See for example the terms and conditions on the Webjet.com.au website http://www.webjet.com.au/about/booking-terms/ and Amazon's Universal Terms of Service https://aws.amazon.com/service-terms/ . 30 GSTR 2000/31 paragraph 65. 31 See for example Private Ruling 1011511098475 at https://www.ato.gov.au/rba/content/?ffi=/misc/rba/content/1011511098475.htm.
An acquisition as defined in section 11-10 of the GST Act includes an acquisition of goods, services and rights. Section 11-15 provides that a thing is acquired for a creditable purpose to the extent that it is acquired in carrying on ITNB's business, except to the extent that the acquisition relates to making supplies that would be input taxed or the acquisition is of a private or domestic nature. Each of the acquisitions that are made by ITNB are acquired in carrying on ITNB's business and are clearly not of a private or domestic nature. There is no potential input taxed supplies being made to which the acquisition relates either.
Considering the acquisition of software, where a supply of rights is made in relation to the copyright in the program itself, which allows the licensee to modify, adapt or copy or otherwise do, for commercial purposes, what would ordinarily be the exclusive right of the copyright owner, that is a supply that is made in relation to rights. Assuming that the software is supplied in Australia, the acquisition of software should be a taxable supply.
Considering the hosting agreement, this would most likely be classified as a supply of a service. The service provider, Macquarie Telecom is in Australia, the server is in Australia and the service is supplied to ITNB in Australia and the supply will likely meet the requisite connection to Australia to be considered a taxable supply.33
The inventory contracts provide that ITNB has access to a retailer's stock on hand if an order is placed by an ITNB customer. This is a supply of a right to purchase the retailer's stock as required. The supply of this right may be said to be done in Australia, as both the retailer/designer and ITNB are in Australia. This too should be considered a taxable supply.
2.3 Record keeping for tax purposes
Record keeping for tax purposes and the requirements of section 262A of the ITAA 1936 also needs to be considered by ITNB when operating its digital business. This includes GST records such as tax invoices, receipts, sales records, year end records, bank records. TR 2005/9 sets out the ATO's approach to record keeping, and has specific paragraphs relating to digital and e-commerce businesses. Records can be kept in written or electronic form. In relation to companies in digital business TR 2005/9 reminds businesses:
30. Where a taxpayer conducts business transactions through the internet or by EDI the Tax Office position is that the taxpayer is required to keep records explaining all such transfers that are relevant for any purposes of the ITAAs. All other requirements relating to electronic record keeping systems, such as the need for controls, are equally applicable.
31. If electronic information systems are used to conduct business transactions such as those that may be conducted by websites, but do not function as record keeping systems, there will be no evidence of those transactions. Without this evidence your organisation or business may not be considered to have complied with its record keeping requirements under section 262A of the ITAA 1936. There is an administrative penalty if you do not keep or retain records as required by this section: see section 288-25 in Schedule 1 to the Taxation Administration Act 1953. Taxpayers should remember that the onus
32 Section 11-5 of the GST Act. 33 GSTR 2000/31 paragraphs 202-206, and also see Private Ruling 1011511098475.
of proof is on them in showing that an assessment is excessive should the Tax Office amend their taxable income. The failure to keep sufficient records to explain relevant transactions for tax purposes would be inconsistent with the requirements of these obligations.
32. The nature of e-commerce with the recording of transactions and information and subsequent record keeping implications will assist taxpayers in the design and implementation of systems to manage full and accurate records arising from e-commerce or EDI for the required periods. [emphasis added]
This is a reminder that another factor ITNB will need to consider when establishing its website is the need for website functionality to ensure that sufficient and complete records are generated by transactions on the website to enable ITNB to meet its record keeping requirements.
3 Going global - expanding the digital business outside of Australia
3.1 Overview of fundamental concepts to consider
The case study suggests that ITNB will establish a subsidiary based in Singapore. A structuring discussion should be had with ITNB about the type of entity that will be established in Singapore (company, trust, partnership) taking into account all the commercial, regulatory, liability and taxation aspects of those varying entity types. For the purposes of this paper we have assumed a simple company structure, with ITNB Singapore Ltd incorporated in Singapore, and the shares in ITNB Singapore Ltd being owned 100% by ITNB.
We have assumed that ITNB has considered all of the varying issues relating to a company structure from a commercial perspective. Setting up a company in Singapore provides limited liability, may enable the company to access and service Asian based clients on the ground more easily, and may provide greater opportunities to enter into contracts in Asia with other suppliers (such as inventory contracts between ITNB Singapore Ltd and designers based in and popular in Asia which may attract further Asian based customers). Considering the local Singapore law issues such as consumer laws, privacy, and security will also be vital. Factors such as funding the Singapore company, and staffing will also need consideration. For the sake of simplicity, it is assumed that staff will all be Singapore based.
Before considering the tax issues for ITNB in expanding its online business offshore, it is important to identify the fundamental concepts underpinning Australia's international tax regime.
Three fundamental concepts of Australia's international tax regime are:
Residence; Source; and Permanent establishment
Australia does not currently have rules which specifically deal with digital businesses. Australia continues to rely on these fundamental concepts in determining the income tax consequences of digital business transactions.
Under the ITAA 1997, an entity resident in Australia is assessable on its worldwide income, irrespective of the source of the income. An entity that is not an Australian resident is only assessable in Australia on income that is Australian sourced (subject to the application of a tax treaty).
3.2 Issues digital businesses need to consider when expanding offshore
3.2.1 ITNB Singapore Ltd as a controlled foreign company – issues for ITNB
The first issue to consider is whether issues could arise for ITNB from its ownership of ITNB Singapore Ltd.
The controlled foreign company (CFC) rules need to be considered when establishing an offshore subsidiary, especially where the subsidiary is established in an unlisted country (that is, a country other than Canada, UK, Germany, France, NZ, Japan and US). If applicable, the CFC rules attribute income of the foreign entity to the Australian parent on an accruals basis and tax that at Australian tax rates.
The CFC rules in Part X of the ITAA 1936 include in the assessable income of an Australian resident attributable taxpayer their proportionate share of a CFC's attributable income.34 Pursuant to section 340 of the ITAA 1936, ITNB Singapore Ltd is a CFC on the basis that all of the shares in ITNB Singapore Ltd are held by ITNB, an Australian resident for income tax purposes. ITNB Singapore Ltd is not resident in a listed country. Pursuant to section 356 of the ITAA 1936, ITNB will be an attributable taxpayer and will have an attribution percentage of 100% as it holds all of the shares and rights to vote in ITNB Singapore Ltd.
The nature of ITNB Singapore Ltd's business and income needs to be considered, to determine whether it passes the active income test. The active income test applies on an annual basis. If ITNB Singapore Ltd passes the active income test, there should be no attributable income to attribute to ITNB for Australian tax purposes.
Sections 432, 433 and 435 of the ITAA 1936 contain the basic conditions for passing the active income test. Section 432 provides, amongst other things, that a company passes the active income test if the tainted income ratio (as set out in section 433) of the company for the relevant statutory accounting period (generally a period of 12 months ending on 30 June) is less than 0.05. This essentially requires that less than 5% of the company's gross turnover is from passive income, tainted sales income or tainted services income.
The CFC provisions include a comprehensive definition of these terms. At a high level, gross turnover of a CFC is based on the accounting revenue in a period. In the context of the case study, income from the provision of services by the CFC can be tainted services income where the recipient of the services is an Australian resident.
Under subsection 448(1)(a), tainted services income includes:
(a) income (other than premium income) from the provision of services by the company to an entity, if:
(i) the entity was a Part X Australian resident at the time the income was derived; and
(ii) the services were not provided in connection with a business carried on by the entity at that time at or through a permanent establishment of the entity in a listed or unlisted country.
There are exceptions from tainted services income but in the case of services in the case study those exceptions do not apply. If ITNB Singapore Ltd provides services to Australian resident customers and/or designers where those customers or designers do not have a permanent establishment outside Australia to which those services are connected, and the fees cannot be otherwise described as royalties,35 the fees from those services will be tainted services income. From the facts of the case study, the Australian customers will continue to be provided services/goods by ITNB and there should be minimal to no Australian customers for ITNB Singapore Ltd as a result. However, given the flexible nature of digital income and the ability of customers to access websites from anywhere, Australian customers may arise for ITNB Singapore Ltd. In addition, ITNB's intentions long term need to be considered. For example, if in future ITNB became a holding company and the website operations were entirely based in ITNB Singapore Ltd for all customers including its current Australian customers, this issue could become more significant.
In addition to potential tainted services income, income from the sale of goods by ITNB Singapore Ltd can be tainted sales income pursuant to subsection 447(1)(a) of the ITAA 1936. This arises where ITNB Singapore Ltd acquires any goods (such as clothing) from ITNB (a Part X Australian resident and an associate) and where ITNB Singapore Ltd does not substantially alter those goods (which seems likely from the facts of the case study). The extent to which ITNB Singapore Ltd derives income from the sale of goods which it acquired from ITNB will need to be considered. Commercially ITNB Singapore Ltd may wish to consider entering into its own alternative inventory agreements if Australian designer clothing is to be supplied by it to customers. When advising ITNB and ITNB Singapore Ltd, this issue needs to be carefully considered.
Further, passive income as defined in section 446 of the ITAA 1936 includes (amongst other matters) tainted royalty income. The issue of whether particular fees paid by customers could be considered a royalty is considered further later in this paper. The tainted royalty income definition in subsection 317(1) of the ITAA 1936 could apply to such income, unless ITNB Singapore Ltd can maintain the royalty payment related to something which originated with it, or was substantially altered or improved by it, substantially enhancing the market value.
From the facts of the case study there is a risk that ITNB Singapore Ltd's income could give rise to tainted services income and/or tainted sales income and/or tainted royalty income. For the establishment of ITNB Singapore Ltd to not give rise to attributed income to ITNB, more than 95% of ITNB Singapore Ltd's income must arise from services to non-Australian customers, from sales of goods which it has not first acquired from ITNB or any other associate, and not from royalties.
It should be noted that if ITNB Singapore Ltd was resident in a listed country,36 the situation could be different. Generally, the CFC rules apply so that Australian controllers of CFCs resident in listed countries are only attributed income that is eligible designated concession income (as defined in subsection 317(1)) as opposed to all passive income such as the tainted sales income, tainted royalty income or tainted services income.
35 The issue of whether the website access fee might be considered a royalty is considered further in this paper. Any such royalties may be passive income if they are tainted royalty income. 36 That is, any of Canada, UK, Germany, France, NZ, Japan and US.
3.2.2 ITNB Singapore Ltd – Australian tax residence
The second issue to consider is whether the income derived by ITNB Singapore Ltd could be assessable in Australia on the basis of that ITNB Singapore Ltd is tax resident in Australia.
Care would need to be taken to ensure that ITNB Singapore Ltd does not become Australian tax resident. If it did, then Australia would have the right to impose tax. The case study assumes that the Australian tax resident company ITNB will hold all of the shares and all the voting power in ITNB Singapore Ltd. That means that tax residency could occur if it could be said that ITNB Singapore Ltd was carrying on business in Australia.37 In addition, for the purposes of Article 3 of the Australia/Singapore Treaty, treatment as an Australian company and an Australian resident may also arise if ITNB Singapore Ltd is managed and controlled from Australia.38 When considering whether ITNB Singapore Ltd could be carrying on a business in Australia there is a raft of case law that would need to be considered, and the factors outlined at paragraph 13 of TR 97/11 should also be considered.39
To meet potential residency risks it would be prudent to ensure that there are business management and governance protocols relating to the operation and management of ITNB Singapore Ltd which are followed and regularly tested. It should be noted that recent Full Federal Court case law has confirmed that if an adviser to the company is effectively making the decisions for the company with offshore directors merely 'rubber stamping' those decisions, the company may have an Australian tax residence.40 This too needs to be considered by ITNB Singapore Ltd and dealt with appropriately in its governance protocols.
We have assumed for the purposes of this paper that protocols will be in place and followed to ensure that ITNB Singapore Ltd is neither carrying on business in Australia nor managed and controlled from Australia.
There are other commercial issues that would need consideration. For example, if ITNB Singapore Ltd is to have its own website, arrangements will be needed between it and ITNB to enable it to utilise software which Paul has made innovations to, or other aspects of the ITNB website functionality. This could lead to royalty payments being required, with withholding tax potentially arising, and transfer pricing related issues would also need to be considered.
3.2.3 ITNB Singapore Ltd – source and the nature of income
On the assumption that ITNB Singapore Ltd is a resident of Singapore only, questions of Australian source and whether there is an Australian permanent establishment need to be considered. Under domestic Australian law, ITNB Singapore Ltd's income is assessable in Australia on income that is Australian sourced, subject to the application of the Australia/Singapore Tax Treaty. If the income at issue is a royalty, dividend or interest and has an Australian source, Tax Treaties generally provide Australia with the right to impose withholding tax.
37 The definition of 'resident' in subsection 6(1) of the ITAA 1936 provides that if a company is incorporated outside of Australia, but has its voting power controlled by shareholders who are residents of Australia and carries on business In Australia, it will be an Australian resident. 38 Article 2 of the Australia/Singapore Treaty provides that a resident of Australia has the meaning provided at domestic law. Article 3 however provides that an Australian resident for treaty purposes includes an Australian company which is a resident of Australia and is managed and controlled from Australia. 39 See http://law.ato.gov.au/atolaw/view.htm?DocID=TXR/TR9711/NAT/ATO/00001. 40 Bywater Investments Limited v Commissioner of Taxation [2015] FCAFC 176.
While under domestic law Australia imposes tax based on source, if an entity is resident in a country with which Australia has a tax treaty, depending upon the nature of the income at issue, Australia's right to tax will be limited based on whether the taxpayer has a permanent establishment in Australia. The first issue is whether the payments that might be derived by ITNB Singapore Ltd could have an Australian source.
Australian source
The term source is not generally defined in the Australian tax law and takes its meaning from common law unless a specific statutory provision determines the source of a particular type of income.41 There are a number of Australian cases considering the concept of the source of ordinary income.42 In general terms those cases hold that ascertaining the source of income is a practical, hard and matter of fact process to be determined on a case by case basis.
Income derived from the provision of services is generally considered to be sourced from the location where the services are performed. In a digital context, rarely will all of the inputs that make up the service offering be conducted in a single jurisdiction, eg if the website is hosted offshore for example.
In general terms, the current position on royalties in Australia is that if royalties are received in respect of property (such as a patent, trade mark or design) the source of those royalties will generally be the country where the property rights are located (potentially where those rights are registered, even if the owner is located elsewhere, but generally this is where the owner is resident).43 If received for technical know-how and services are supplied outside that country under an agreement made outside that country, the source of those royalties would generally be outside that country.44
Adding to that is section 6C of the ITAA 1936. Section 6C provides that all royalty income derived by non-residents such as ITNB Singapore Ltd is deemed to have an Australian source to the extent that the payment is an outgoing of an Australian business carried on at or through a permanent establishment in Australia (irrespective of the place of payment or where the contract giving rise to royalties has been made).
While it is critical to first identify the source of income (as where the income is not Australian sourced, Australia will not have a taxing right), to determine the source of an item of income, its character must be confirmed.
Characterising the income derived by ITNB Singapore Ltd for Australian income tax purposes
On the basis that ITNB Singapore Ltd is not a resident of Australia for Australian income tax purposes, the key challenge in relation to identifying the income tax consequences of the transactions between ITNB Singapore Ltd is the characterisation of the fees payable to ITNB Singapore Ltd by any Australian customers and Australian designers.
To determine the source and character of the income derived from a digital transaction requires identification of the nature of the transaction. In the context of Double Tax Treaties (such as the Australia/Singapore Treaty applicable to the case study) the most difficult area in respect of income from digital services seems to be differentiating between royalty income and business profits.
41 Amongst other provisions, section 6B and section 6C of the ITAA 1936 provide some limited source rules. 42For example, Nathan v FCT (1918) 25 CLR 183, FCT v Mitchum (1965) 113 CLR 401, Esquire Nominees Limited v FCT (1972) 129 CLR 177 and Thorpe Nominees Pty Limited v FCT (1988) 19 ATR 1834. 43 FC of T v United Aircraft Corporation (1943) 68 CLR 525 and Curtis-Brown Ltd (as agents for Stella Benson & Others) v Jarvis (1929) 14 TC 744 (there are copyright had been registered in the UK, the UK was the source of property). 44 See for example FC of T v Sherritt Gordon Mines Ltd 77 ATC 4365.
To illustrate that difficulty, the issue has been recently considered in Tech Mahindra Ltd v Commissioner of Taxation [2015] FCA 1082, and this case is under appeal to the Full Federal Court (to be heard in 2016). In the Tech Mahindra case Article 7 (the business profits article) and Article 12 (the royalty article) of the Australia/India Double Tax Treaty (pre-2011 amendments) was considered. The taxpayer had offices in Australia, but the IT and software development services it provided customers in Australia included services provided by Indian based employees performed online from India. The taxpayer maintained that to the extent income derived from Australia customers related to the services of Indian employees that income was not taxable in Australia as it was not attributable to the taxpayer's permanent establishment in Australia, the Commissioner contended otherwise and also argued as an alternative that the payment was a royalty. The Federal Court held that the payments were 'royalties' as defined in the Australia/India Double Tax Treaty as they consisted of the 'rendering of any services (including those of technical or other personnel) which make available technical knowledge, experience, skill, know how or processes or consist of the development and transfer of a technical plan or design'. In addition, the Court held that the royalties arose in Australia as they were paid by Australian customers for an Australian contract, and accordingly Australia could impose tax.
Amongst other matters, the case also considered whether the income was attributable to the taxpayer's permanent establishment in Australia under Article 7 by virtue of factors such as the contracts with Australian customers being entered into in Australia. The Full Federal Court appeal in 2016 may prove of interest in relation to that issue as well.
The ordinary meaning of the word royalty has been considered in Australian case law on numerous occasions.45
In addition, subsection 6(1) of the ITAA 1936 and the ATO ruling IT 2660 (at paragraph 10) outline an expansive definition of royalty, including payments made or credited in return for:
(a) the right to exercise a beneficial privilege or right (for example, to use a copyright);
(b) the use of, or the right to use, any copyright patent, design or model, plan, secret formula or process, trademark, or other like property or right
(c) the use of, or the right to use, any industrial, commercial or scientific equipment;
(d) the supply of scientific, technical, industrial or commercial knowledge or information (for example, know-how);
(e) the supply of any assistance that is ancillary and subsidiary to, and is furnished as a means of enabling the application or enjoyment of, any such property or right mentioned above;
(f) the use of, or the right to use, motion picture films, films or video tapes for use in connection with television, or tapes for use in connection with radio broadcasting; or
(g) a total or partial forbearance in respect of the use of, or the granting of the right to use property of any of the kinds mentioned above;
(h) the supply of knowledge, information or assistance in some circumstances.
45 See for example Stanton v FCT (1955) 92 CLR 630, McCauley v FCT (1944) 69 CLR 235, Sherritt Gordon Mines Ltd (1977) 137 CLR 612, Barrett v. FCT. (1968) 118 CLR 666.
It should be noted that the definition of royalties, in the extended definition in section 6(1) of the ITAA 1936, is broader than the definition of the term in the OECD Commentary on Article 12 of Double Tax Treaties (which is generally the royalty article, although in the Singapore Treaty the relevant Article is Article 10).
The OECD definition which is generally utilised in Tax Treaties sets out the ordinary meaning of the term royalty plus know-how and the right to use industrial, commercial or scientific equipment. By virtue of subsection 4(2) of the International Tax Agreements Act 1953 (Cth) a Tax Treaty will prevail if there is a difference with Australian domestic law. However, the process would be to consider Australian law first, then the Treaty.
On the facts of the case study, the income derived by ITNB Singapore Ltd from transactions with customers may not fall within the meaning of royalty either under the domestic test or the OECD definition. Where there is no use of or right to use any intellectual property or equipment, the transaction is more appropriately considered a service. However, there are potential royalty issues in respect of website access fees. Website access fees may involve the transfer of a non-exclusive property right in the form of a right to use the intellectual property or software comprising the website – although such a right is often described as 'royalty free' unless the nature of the rights provided to customers is very clearly described in the terms and conditions, the ATO may take a different view of the website access fee and what it is consideration for. In addition, any applicable fee for downloading the App developed by Paul, Jane and Brian Block may also have royalty implications, depending upon the contractual rights and obligations. Those implications could also arise under the tax treaty definition of royalty. In addition, depending upon the nature of the website hosting agreements entered into by ITNB Singapore Ltd and on Singapore law definitions, royalties might arise in respect of any such hosting payments.46
The question will be whether there is an Australian source for those fees if they are derived by ITNB Singapore Ltd. If there is an Australian source, withholding tax can arise, at the applicable Treaty rate. In general terms, an Australian source might arise where there are Australian customers and/or where contracts entered into by ITNB Singapore are made or performed in Australia. Care would need to be taken in the ITNB Singapore Ltd website terms and conditions to describe carefully what payments derived by ITNB Singapore Ltd are for, and where contracts are concluded with customers and carried out by ITNB Singapore Ltd. In a digital environment issues such as where signals are received and where the infrastructure is located that hosts the ITNB Singapore Ltd website will need to be considered when determining where contracts are 'made'.
Section 6C of the ITAA 1936 also cannot be forgotten. It provides that all royalty income derived by ITNB Singapore Ltd is deemed to have an Australian source to the extent that the payment is an outgoing of an Australian business carried on at or through a permanent establishment in Australia (irrespective of the place of payment or where the contract giving rise to royalties has been made). As is stated above, we have assumed that ITNB Singapore Ltd will not be carrying on business in Australia, but for the purposes of this paper, we highlight the expanded definition of permanent establishment in the ITAA 1936 to demonstrate how a digital business could easily be caught by section 6C of the ITAA 1936.
46 This depends upon the nature of the cloud services. If there is a pure service without property rights being licensed, no royalties should arise. If property is licensed but there is no right to copy or modify underlying code, this too may not be a royalty. If property is licensed and there is the ability to modify software, this may comprise a royalty. Further discussion of this issue can be found in Frank Putrino and Brendan Rynne's paper Cloud computing – Understanding the tax and transfer pricing implications 10-11 October 2013 – presented at the Tax Institute's 2013 Victorian Annual Tax Forum. The OECD's BEPS project also considered this issue. In BEPS Action 1, Addressing the Tax Challenges of the Digital Economy the OECD suggested that the nature of payments to cloud providers and whether they are royalties should be considered and clarified more generally.
The definition of permanent establishment in subsection 6(1) of the ITAA 1936 includes a place where there is substantial equipment and, critically, includes where goods sold by ITNB Singapore Ltd are packed and distributed (amongst other matters) by a person (such as ITNB) and the management, control or capital of ITNB Singapore Ltd is participated in by ITNB or there is common management, control or capital participation in ITNB Singapore Ltd and ITNB. That aspect of the permanent establishment definition may well catch ITNB Singapore Ltd were it carrying on business in Australia, to the extent that it indirectly utilises ITNB's current inventory contracts with Australian suppliers, ITNB packs and distributes goods for it (or an agent of ITNB does so), and where ITNB Singapore Ltd does not enter into its own inventory contracts.
Finally, when considering other aspects of the permanent establishment definition in subsection 6(1), the case study does not give us facts as to where the ITNB Singapore Ltd website will be hosted, and whether it is in fact just an adjunct of the ITNB website. Under current law, if there is substantial infrastructure hosting the website that ITNB Singapore Ltd is entitled to access, that can form a permanent establishment for ITNB Singapore Ltd. A permanent establishment might also arise through an agent, and the arrangements between ITNB and ITNB Singapore Ltd would need careful consideration to ensure that risk is minimised.
OECD commentary on the Treaty definition of permanent establishment suggests that a distinction needs to be made between computer equipment which is at the disposal of the taxpayer (which may constitute a permanent establishment) and the data and software used or stored on that equipment. An internet website should not in itself constitute tangible property and cannot constitute a 'place of business' (per the subsection 6(1) definition for domestic law purposes).
Were ITNB Singapore Ltd to be using cloud based services under a hosting arrangement,47 rather than through a server that is owned, leased, operated or otherwise at its disposal, this should not give rise to a permanent establishment of ITNB Singapore Ltd in Australia.
Following considering all of that, ITNB Singapore Ltd would also need to consider the Treaty, and whether it might alleviate the potential for tax to arise on any such royalties in Australia.
To conclude, a tax adviser to ITNB Singapore Ltd should be involved in the drafting of the website terms and conditions, ensuring fees are accurately described as to what they are for, and ensuring contracts with customers are entered into when and where they are intended to be. A tax adviser would also need to work with the company to establish its business appropriately in the jurisdictions it intends operating in. Finally, for the reasons set out above, care would need to be taken to find out about the website hosting arrangements and ITNB Singapore Ltd's inventory arrangements.
Source of ITNB Singapore Ltd's services income
Similarly to the issues in relation to royalties, the issue when determining the source of ITNB Singapore Ltd's services income revolves around where services are performed, and, depending upon the facts, where contracts are made: C of T (NSW) v Cam & Sons Ltd (1936) 4 ATD 32 Thorpe Nominees Pty Limited v FCT (1988) 19 ATR 1834.
47 The 'cloud' refers to software-as-a-service, infrastructure-as-a-service or platform-as-a-service facilities hosted by providers. The nature of the cloud and the differences between these options is further explained in detail at the Tax Institute's 29th National Convention in E-Commerce, Cloud and Cross-Border Transactions by Sypros Kotsopoulos and Manisha Singh of Deloitte (2014) at page 7 of the conference paper. Cloud computing is also explained in a paper delivered by Frank Putrino and Brendan Rynne of KPMG in October 2013 at the Tax Institute's Victorian Annual Tax Forum Cloud computing – Understanding the tax and transfer pricing implications 10-11 October 2013. This paper will not reproduce all of that analysis, and both of those papers are recommended as a resource.
The fees paid by Australian customers to ITNB Singapore Ltd, in consideration for the services provided by ITNB Singapore Ltd, may be a service which is performed outside of Australia, where the staff who provide the service are located wholly outside of Australia.48 Insufficient facts are given in the case study to be able to determine that, and a tax adviser would need to discuss that further with ITNB Singapore Ltd. Given the nature of the business, a tax adviser to ITNB Singapore Ltd would need to consider the arrangements with ITNB in particular and whether any services will be carried out by ITNB staff acting for ITNB Singapore Ltd.
As stated above, where contracts are made and performed, where signals are received concluding contracts, where the hosting and infrastructure is located, and ITNB Singapore Ltd's website terms and conditions will all be relevant to consider when determining whether the services have an Australian source.
Assuming that customers are not Australian resident, ITNB Australian staff are not involved in any way with the ITNB Singapore Ltd business (eg no packing or distribution of goods), there is no website hosting infrastructure for ITNB Singapore Ltd in Australia and contracts with customers and designers are not made in Australia, it seems unlikely that this income could have an Australian source.
3.2.4 Permanent establishment
Current tax law
In the context of the digital economy and assuming a tax treaty applies, payments for the provision of technical services are generally covered by the business profits article of Australia's treaties. This means that unless the income could be characterised as other than business profits (eg royalties) and unless ITNB Singapore Ltd has established a permanent establishment in Australia it will unlikely be taxed in Australia on the income derived from its digital services.
If ITNB Singapore Ltd were resident in a country with which Australia does not have a tax treaty and the payments are Australian sourced, Australia could have a right to tax those payments – however that is not the position from the case study so it is not considered further.
In general terms tax treaties provide for the country of residence (Singapore for ITNB Singapore Ltd) to impose taxation, other than where business is carried on through a permanent establishment in the other jurisdiction (Australia), and profits are attributable to that permanent establishment. For a purely digital business such as ITNB Singapore Ltd, if there is no actual office in Australia, and ITNB is not the agent of ITNB Singapore Ltd, a permanent establishment is only likely to arise through an agent (such as ITNB), or because there is substantial equipment located in Australia.
The definition of permanent establishment for Treaty purposes is set out in Article 5 (Article 4 for the Australia/Singapore Treaty). The OECD Commentary on article 5 of the OECD Model Tax Convention establishes a distinction between computer equipment (which may constitute a permanent establishment) and the data and software used or stored on that equipment. The Commentary suggests that a website does not in itself constitute tangible property and cannot constitute a 'fixed place of business' as required by the permanent establishment definition in the Model Tax Convention. However, the server may constitute a 'fixed place of business' in some circumstances.
48 In this regard the Tech Mahindra case (supra) considered above in paragraph 3.2.3 needs to be considered.
The OECD Commentary also states that where a website is hosted on the server of an internet service provider, this does not typically result in the server and its location being at the disposal of the enterprise. In such cases, the enterprise cannot be considered to have acquired a place of business by virtue of that hosting arrangement. However, if the enterprise carrying on a business through a website has the server at its own disposal, for example it owns or leases and operates the server on which the website is stored and used, the place where the server is located could constitute a permanent establishment.
In relation to agents, for the purposes of the Australian/Singapore Treaty, Article 4 provides that it is only where an agent is not of independent status, and (amongst other matters) is able to habitually conclude contracts (other than those limited to the purchase of goods and merchandise). An issue that ITNB Singapore Ltd would need to ensure is that arrangements with ITNB (if there are any) do not give rise to an agency arrangement that might establish a permanent establishment for ITNB Singapore Ltd in Australia.
From the limited facts in the case study, it does not seem likely that a permanent establishment could arise in Australia for ITNB Singapore Ltd. However further facts would need to be sought to ensure that was the position. In any event, income needs to be attributable to any such permanent establishment before Australia would have the right to tax it, and again, depending on obtaining further facts, ITNB Singapore Limited may be able to maintain that its services to Australian customers are entirely attributable to its offshore operation.
It would also be sensible for ITNB and ITNB Singapore Ltd to consider the potential future position in relation to when a permanent establishment arises.
OECD's BEPS project – potential future changes
One of the Action Points in the OECD's BEPS Project is Action 1, Addressing the Tax Challenges of the Digital Economy.
The OECD's discussion paper in late 2014 highlighted BEPS issues which arise from the digital economy including:
Whether current physical nexus tests for residence or the existence of a permanent establishment continue to have relevance in the digital economy, as there is an inability for the country of customer source to impose tax on a purely digital transaction if the e-commerce entity is neither tax resident nor has a physical presence in that jurisdiction.
Options for amendments to the concept of permanent establishment which were considered included whether a permanent establishment might arise if (1) the enterprise operates 'fully dematerialised digital activities' (measured by reference to whether the core business relies completely or in large part on digital goods and services); or (2) has a 'significant digital presence' (eg measured through volume of digital sales, numbers of customers, expenditure in a jurisdiction, the significance of the digital presence to the overall business); or (3) there is a 'virtual fixed place of business' – eg a website on a server of another business; or (4) there is a 'virtual agency' – eg via sales staff in a jurisdiction, or via the digital conclusion of contracts; or (5) there is an 'onsite business' presence – eg via an interface on a customer website.
Fragmenting physical operations to avoid taxation – for example by centralising infrastructure at a distance from the market jurisdiction, and conducting substantial sales remotely using minimal personnel.
Business structuring using offshore entities to create base erosion and profit shifting opportunities especially via the transfer of ownership of intangible property - structures achieving this have
been adopted by some of the world's leading technological companies including the infamous Double Irish Dutch sandwich structure.
The characterisation of payments such as cloud computing payments for tax purposes, and whether they ought to be subject to withholding tax.
Avoiding VAT or GST by having no presence in a country where the bulk of the profits are made.
In its final paper on Action 7 of the BEPS Project Preventing the Artificial Avoidance of Permanent Establishment Status the OECD made recommendations to amend the permanent establishment concept in the model convention. The recommendations included the following:
Modifying the exclusions from the concept of permanent establishment so that the exceptions are restricted to activities that have a preparatory or auxiliary character. For example, the maintenance of a very large warehouse in which a significant number of employees work for purposes of storing and delivering goods sold online to customers by an online seller of goods could constitute a permanent establishment under the new standard.
Modifying the definition of permanent establishment to address circumstances in which artificial arrangements relating to the sale of goods or services of one company in a multinational group effectively result in the conclusion of contracts, such that the sales would be treated as if they were made by that company. For example, where the sales staff of an online seller of goods or services routinely concludes contracts without material modification by the parent company, a permanent establishment may arise for the parent company.
It is unclear whether and to what extent the changes to the permanent establishment concept in the model convention may be adopted into Australia's double tax treaties. However, if implemented, the proposed changes could have wide-reaching effects for digital businesses including broadening the circumstances in which a permanent establishment may arise in Australia and its treaty counterparties. The ATO is closely involved in considering these issues. When expanding offshore, the ITNB group should consider and, where possible, future proof the business from those potential issues.
The new multinational anti-avoidance law – permanent establishment avoidance
For completeness, although these provisions are unlikely to be relevant to the ITNB group given its turnover (unless the turnover substantially increases), we note that the Tax Laws Amendment (Combating Multinational Tax Avoidance) Act 2015 (Cth) passed through Parliament on 11 December 2015. The Treasurer, Scott Morrison, referred to this legislation when responding to the finalised papers in the OECD's BEPS Project suggesting that it was a measure designed to counter the artificial avoidance of a permanent establishment.49
The stated intention of the new provisions is to counter the use by particular multinationals50 of artificial or contrived arrangements to avoid the attribution of profits through a taxable presence in Australia. The new provisions amend Part IVA of the ITAA 1936. The new rules could potentially be applied by the Commissioner to counter the tax benefit51 and apply an administrative penalty of 100% in the following circumstances:
49 See Press Release 6 October 2015 OECD report supports Australian Government action on multinational tax avoidance http://sjm.ministers.treasury.gov.au/media-release/003-2015/. 50 The rules apply to entities deriving more than $1 billion in annual global income on a consolidated accounting basis (note: this can be determined by the Commissioner). 51 Broadly, using his reconstruction powers in Part IVA, alongside applying penalties and interest, the Commissioner would deem arm's length profits from Australian business to be taxable in Australia in a deemed permanent establishment.
a foreign entity in a multinational group makes a supply52 of goods and/or services to unrelated Australian customers; and
activities are undertaken in Australia by an associated or commercially dependent Australian entity or permanent establishment directly in connection with the supply; and
the foreign entity obtains ordinary or statutory income from the supply; and some or all of that income is not attributable to an Australian permanent establishment of the
foreign entity; and it would be concluded that taking into account particular factors53 that the entry into the scheme
was for the principal purpose54 of or for more than one principal purpose that includes the obtaining of a tax benefit; and
the provisions apply whether or not the scheme has been carried out or entered into in Australia.
Other aspects of Part IVA such as the existence of a tax benefit still need to be applied as well as the above circumstances.
Again, for case study purposes, even assuming that the global turnover requirement55 is satisfied by the ITNB group (which from the facts does not seem likely), the involvement of ITNB Singapore Ltd with Australian customers, and the involvement of ITNB or any other entity in assisting ITNB Singapore Ltd in Australia need to be clarified before it can be determined whether these new provisions are an issue for ITNB Singapore Ltd and the ITNB group. The Explanatory Memorandum to the Tax Laws Amendment (Combating Multinational Tax Avoidance) Act 2015 (Cth) provides useful guidance as to when the provisions are intended to apply.
3.2.5 Transfer pricing
This paper will not canvas in any detail the transfer pricing issues which may arise for an Australian group expanding its digital offshore, as those are more general issues, not specifically related to digital business, and comprise a paper within themselves. Issues relating to transfer pricing implications for entities involved in cloud computing and those involved in offshoring their business have also been canvassed extensively in prior Tax Institute papers. As has been mentioned above, if ITNB provides services to ITNB Singapore Ltd, including for instance, access to website functionality, arm's length consideration needs to be provided for any such services.56
When ITNB determines to expand its business offshore and establish ITNB Singapore Ltd, establishing a detailed transfer pricing policy for the group is a sensible first step, and it is critical to be aware of the documentation requirements in section 284-255 of Schedule 1 to the Taxation Administration Act 1953 (Cth), and also (if applicable) country-by-country reporting57 and the potential for simplified transfer pricing documentation requirements to be applicable.58 It is critical to meet the documentation requirements, and
52 Note that supply in this context has the GST Act meaning, and excludes supplies of debt or equity interests, or of options for debt or equity interests. 53 Along with the existing factors in subsection 177D(2) of the ITAA 1936, factors considered include the extent to which activities are carried out by the varying entities in the arrangement, and the foreign tax law result that would be achieved by the scheme. A deferral of foreign tax is taken to be a reduction of that tax, unless there are reasonable commercial grounds for the deferral. 54 This is notably different to the dominant purpose test in the remainder of Part IVA. 55 See footnote 48. 56 Further analysis of transfer pricing implications can be found in Cloud computing – Understanding the tax and transfer pricing implications by Frank Putrino and Brendan Rynne of KPMG 10-11 October 2013, presented at the Tax Institute's Victorian Annual Tax Forum, and in Offshoring or Exporting – The ATO's Approach to your cross-border transactions with related parties by Frank Putrino, KPMG, 3 May 2013, presented at the Tax Institute's 46th South Australian Convention. 57 Country-by-country reporting requirements passed the Australian Parliament on 11 December 2015. Those rules apply to entities with annual global income of $1 billion or greater. See further details at https://www.ato.gov.au/General/New-legislation/In-detail/Other-topics/International/Country-by-Country-Reporting-and-Transfer-Pricing-Documentation/. 58 See TR 2014/8, TR 2014/6, PS LA 2014/2 and PS LA 2014/3 for further detail.
it should be noted that unless the documentation requirements are satisfied, a taxpayer does not have a reasonably arguable position.59
3.2.6 GST
In expanding the online business offshore, the treatment of supplies to Australian customers as opposed to overseas customers can be different for GST purposes.
Based on the current structure of ITNB, its servers are located in Australia (hosted by Macquarie Telecom) and it has a head office in Australia. As discussed above, ITNB's supplies made in Australia will be subject to GST. Where a supply is made by ITNB from Australia to a customer overseas, where there is an export of goods (in this instance clothes) this supply will be GST free if the export occurs within 60 days after the day on which consideration is received for the supply or, if on an earlier day the supplier gives an invoice for the supply, then the day that the invoice is supplied.60 If ITNB supplies an overseas customer with a service, a supply of things (other than goods or real property) for consumption outside Australia61 should be GST free if the customer is not in Australia when the supply is made and the effective use or enjoyment of the supply takes place outside of Australia, or the customer is not registered for Australian GST.62
If ITNB Singapore Ltd supplies Australian customers with goods (such as clothing), assuming that those supplies are imported by the Australian customer, and are less than the low-value threshold (currently $1,000, but potentially soon to be abolished due to agreement with the States and Territories),63 GST should not arise.
If the ITNB group website was hosted in the cloud by an offshore service provider, if all servers were located offshore, and ITNB determined to centralise the provision of all services to customers in ITNB Singapore Ltd, under current law this could mean that there is not a supply connected with Australia as defined in section 9-25 of the GST Act, and as is required by section 9-5 of the GST Act. This is because ITNB Singapore Ltd would not have the requisite connection with Australia, if it had no permanent establishment in Australia, and did not carry on an enterprise in Australia, and the service is 'done' outside of Australia. As was described above, in various private binding rulings issued to taxpayers, the ATO has determined that the supply of online services by a foreign company to Australian customers is not done in Australia where the foreign company's servers are not in Australia.64
However, this may not always be the position. The Tax Laws Amendment (GST Treatment of Cross-Border Transactions) Bill 2015 (Cth) issued in October 2015 (although not passed at the time of drafting this paper) proposes to expand the GST base to apply to cross border supplies of digital products and services from 1 July 2017. It is colloquially known as the Netflix tax.
In broad terms, the new provisions would apply as follows:
Supplies of things other than goods or real property will also be connected with Australia and therefore potentially subject to GST if the recipient of the supply:
59 Section 284-250 of Schedule 1 to the Taxation Administration Act 1953 (Cth). 60 Section 38-185 of the GST Act. 61 The concept in the GST Act (effective 1 July 2015) is now the indirect tax zone as defined in section 995-1 of the GST Act. This change occurred by virtue of the Treasury Legislation Amendment (Repeal Day) Act 2015 (Cth). For simplification purposes this paper refers to "Australia" but the indirect tax zone definition is the appropriate reference to consider. 62 Section 38-190 of the GST Act. 63 See http://sjm.ministers.treasury.gov.au/media-release/003-2015/. 64 See for example Private Ruling 1011511098475 at https://www.ato.gov.au/rba/content/?ffi=/misc/rba/content/1011511098475.htm.
• is not registered or required to be registered for GST; and • is an Australian resident. Accordingly, supplies of digital products, such as streaming or downloading of movies, music, apps, games, e-books as well as other services such as consultancy and professional services may receive similar GST treatment whether they are supplied by a local or foreign supplier. The offshore supplier must take 'reasonable steps' to identify if consumers are Australian resident.
In some circumstances, a GST liability may be imposed on the operator of an electronic distribution service through which the supply is made to the consumer rather than the actual supplier. However, this shift in responsibility for GST liability will only apply if the electronic distribution service controls one or more key elements of the supply to the recipient. These include any of the following: • the supplier is not identified in relevant documents; • the operator authorises billing; • the operator authorises delivery of the supply; or • the operator sets the terms and conditions of the supply. Although the amendments impose GST liability on the operator (rather than the actual supplier) if specific criteria are met, they do not result in any change to the amount of the GST.
• A modified GST registration and remittance scheme will apply. Simplified administrative rules will be able to be made by regulations in relation to entities that are registered or required to be registered for GST purposes; tax periods; and GST returns; for entities that make supplies that are connected with the Australia (and the indirect tax zone) because of the amendments.
As is also noted above, the OECD's BEPS project also considered GST/VAT in its paper on Action 1, Addressing the Tax Challenges of the Digital Economy and the OECD has also issued International VAT/GST Guidelines.65 A number of other jurisdictions, notably the European Union, have adopted or are considering GST/VAT legislation of a similar impact as the Australian proposals. Depending upon where the ITNB operates in future and local law registration thresholds, it may be required to register for these indirect tax / VAT schemes in the countries in which it supplies digital services.
3.2.7 Digital currency
The case study lastly refers to ITNB wanting to understand the tax treatment if it accepts crypto-currency such as bitcoins. Bitcoin is a type of crypto-currency that utilises cryptography to ensure a secure transaction occurs. The ATO has provided guidance by way of determinations and rulings,66 and by way of a November 2014 submission 8 to the Senate Economics References Committee – inquiry into digital currency.
The ATO's guidance is as follows:
A bitcoin is a form of intangible property, and is not money or currency. A bitcoin is not foreign currency for the purposes of Division 775 of the ITAA 1997. A bitcoin is a CGT asset for the purposes of subsection 108-5(1) of the ITAA 1997. Where the cost of the bitcoin was less than $10,000 and where an individual uses it to purchase
personal items, there will be no CGT obligations in accordance with subsection 108-20(1).
65 See 6 November 2015 version at http://www.oecd.org/ctp/consumption/international-vat-gst-guidelines.htm 66 TD 2014/25, TD 2014/26, TD 2014/27, TD 2014/28, GSTR 2014/3.
Otherwise, depending upon the facts, gains on the disposal of bitcoins will either be subject to CGT, or if part of a business operation (as would be the case with ITNB) it will be assessable as ordinary income, and the equivalent value of bitcoin in Australian dollars must be included in assessable income.
A supply of bitcoin in return for goods or services will be treated as a barter transaction for GST purposes.
A transfer of bitcoin is a supply for GST purposes, and the exclusion from a supply for supplies of money is not applicable as bitcoin is not money.
Bitcoin is also not a financial supply under section 40-5 of the GST Act, nor a voucher under Division 100, nor is bitcoin goods, so bitcoin cannot generate input tax credits under Division 66 (relating to second-hand goods).
Separate GST consequences may arise for transactions involving bitcoin conversion. Businesses converting bitcoin into a currency must remit GST on the supply of the bitcoin. For example, ITNB sells an Australian customer a dress retailing at $1,650 including GST.
The Australian customer elects to pay for the dress in bitcoin. ITNB would have a GST liability of $150 (1/11 x $1650).
Using a bitcoin exchange, ITNB converts the bitcoin received into Australian dollars. A 1% commission is charged on the published exchange rate. ITNB receives $1,633.50 in exchange for the bitcoin it held. The supply of bitcoin by ITNB is considered by the ATO to trigger a GST liability of $148.50 (1/11 x $1,633.50) less an input tax credit that may be available for the commission payable to the exchange business.
This means that (ignoring the input tax credit) ITNB has a total GST liability of $298.50 as a result of accepting bitcoin.
If the Australian customer had paid in Australian dollars rather than bitcoin, ITNB's GST liability would have been $150.
This example demonstrates that unless the ATO changes its position in future,67 ITNB may wish to reconsider potentially accepting bitcoins from customers.
67 The Senate Economic References Committee suggested the ATO ought to change its position – see http://www.afr.com/technology/senate-committee-says-bitcoin-should-be-treated-as-a-regular-currency-20150731-gior3u.
4 Conclusion This paper demonstrates that when a small Australian business transitions into having a digital presence, a number of quite specific tax considerations arise, particularly in relation to the deductibility of costs, the nature of income/expenses and the nature of supplies being made. When that same business then transitions to become a global digital business, issues of source, residence, whether there is a permanent establishment, and the nature of income and expenses come to the forefront. Australia's international tax rules, including the CFC regime and transfer pricing regime also need careful consideration.
Complicating matters for businesses in the digital economy is the potential for tax reform both at a domestic level (such as the multinational anti-avoidance law, or GST Netflix tax) and potentially internationally following the OECD's BEPS project (such as changes to double tax treaties which may arise through the adoption of a multilateral instrument).68
While all of those matters do need navigation from a tax perspective, there are also a myriad of commercial issues that require consideration first. None of the tax issues or commercial issues are insurmountable, and there is a greater deal of guidance from the varying governments in Australia, and a great deal of expertise across a range of service providers that can be invaluable when a business is making the transition to a digital presence.
What is clear from the growth of the digital economy in Australia and abroad, is that the digital economy is growing at an exponential rate, and businesses that accept the challenge are accessing new markets and consumers in ever increasing numbers.
68 BEPS Action 15 is to Develop a multilateral instrument under which the OECD proposes there to be a multilateral agreement which leads to the amendment of a large array of double tax treaties. The Treasurer has stated that Australia intends to agree this by December 2016. See http://sjm.ministers.treasury.gov.au/media-release/003-2015/.
